Microeconomics for mbas: The Economic Way of Thinking for Managers, Second Edition

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Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition

Richard B. McKenzie and Dwight R. Lee

Applications of the economic way of thinking: international and environmental economics



Reading 5.2: The cases for and against free trade

In chapter 5, we developed the arguments for and against free trade in general terms. Here we take up in more detail the key arguments on both sides of the debate that have been used since economics became an organized discipline.

The case for free trade

We have seen how international trade can on balance increase the total incomes of the nations engaged in it, although export producers gain and producers that provide substitutes for imports lose. And even those who work for and receive profits from a domestic industry that is harmed by having to compete with foreign imports are generally better off in an economy where all domestic industries are subject to foreign competition than they would be in an economy where all industries are protected against that competition. By extension, we can conclude that anything that restricts the scope of trade between nations generally reduces those nations’ real incomes. To the extent that trade is a two-way street – that exports trade for imports, at least in the long run – a reduction in imports brings a reduction in exports. From US imports, the Chinese get the dollars they need to buy US exports. If the United States reduces its imports, the Chinese will have fewer funds with which to buy US goods. For this reason, US farmers, who sell approximately one-third of their crops in foreign markets, actively opposed the protectionist movement led by textiles, steel, and copper firms.

Yet what is true for one sector of the economy is not necessarily true for all. As just indicated, if all sectors are protected by tariffs, it is possible (but not inevitable) that all will experience a drop in real income. Figure R5.2.1 illustrates the case of an economy with two industries – automobiles and textiles – in a game-theoretic framework. Both industries must compete with imports. If neither seeks protection, both will operate in Cell I, at a combined real income of $50 ($20 for the textiles industry and $30 for the automobile industry). If the textiles industry receives protection but the auto industry does not, they will move to Cell II, where tariffs raise the textiles industry’s income from $20 to $23. The automotive sector’s income falls to $25, so that the two industries’ combined real income falls to $48. Consumers get fewer textiles at a higher price and the automobile sector exports fewer cars.

Similarly, if the auto industry receives protection while the textiles industry does not, the economy will move from Cell I to Cell III. Again, total real income falls, this time from $50 to $49, with the auto industry better off. Its income rises from $30 to $34, but the textiles industry’s income falls to $15. Obviously, if one industry seeks protection, the other has an incentive to follow suit. If the textiles industry counters with a tariff of its own, the economy will move from Cell III to Cell IV, and the industry’s real income will rise from $15 to $17.

Without some constraint on both sectors, then, the two industries are in the kind of Prisoner’s Dilemma considered throughout this book, where each has an interest in seeking protection regardless of what the other does. Yet if the economy winds up in Cell IV, total real income will be lower than under any other conditions: only $43. Obviously the best course for the economy as a whole is to prohibit tariffs altogether, and in an economy with only two sectors, the cost of reaching an agreement is manageable. The real world, however, has many economic sectors, and the costs of reaching a decision are much greater.

In figure R5.2.1, both industries end up with lower real incomes in Cell IV, but in reality, the effects of multiple tariffs will be different in different sectors of the economy. Although total real income will fall, several sectors may realize individual gains. Consider figure R5.2.2. Although total real income falls from Cell I ($50) to Cell IV ($48), the auto sector’s income rises (from $30 to $31). In this case, the textile sector bears the brunt of tariff protection and the auto sector has a compelling interest in obtaining protective tariffs. The sectors of the economy that are most adept at manipulating the political process will be the least willing to accept free trade.

Although it is true that for a nation some trade is better than no trade, it is not necessarily true that free trade is better than restricted trade. Even though protectionism promotes economic inefficiency in the aggregate, a nation may under certain conditions act like a monopolist and improve its share of the gains through trade restrictions. Similarly, the owners of relatively scarce factors of production may be better off with restricted trade. But even in this case, world income is reduced by the trade restrictions. What one country gains, other countries lose. And if all countries try to benefit from trade restriction, they all lose.

Economists generally choose free trade for all because of its obvious benefits to the nation as a whole, or certainly the world as a whole. For example, two economists estimate that because the US average tariff rate fell from 40 percent in 1946 to 4 percent in 2005 and because of the greater international mobility of resources and goods and services, US income grew by roughly $1 trillion, or 10 percent of GDP, which implies that “after a half-century of shrinking distances and commercial liberalization, the average American household enjoys an income gain of about $10,000 per year” (Hufbauer and Grieco 2005). But, as we note in the next section, the case for free trade has several legitimate exceptions, and even the trade restrictions necessary for the achievement of public benefit can be abused by those who would seek to obtain trade protection for private purposes.

The case for restricted trade

Proponents of tariffs rarely argue that they will serve their private interests at the expense of the public by raising prices, and reducing the availability of goods. Instead, they typically advocate tariffs as the most efficient means to accomplish some national objective. Any private benefits that would accrue to protected industries are generally portrayed as insignificant side-effects.

Although most arguments in favor of tariffs camouflage the underlying issues, one is at least partially valid. It has to do with the maintenance of national security.
The need for national security

Pro-tariff arguments based on national or military security stress the need for a strong defense industry. If imports are completely unrestricted, certain industries needed in time of war or other national emergency could be undersold and run out of business by foreign competitors. In an emergency, the United States could then be dependent on possibly hostile foreign suppliers for essential defense equipment.1 Tariffs may create inefficiencies in the allocation of world resources, but that is one of the costs a nation must bear to maintain military self-sufficiency and hence a strong national defense.

Given the wavering popularity of US foreign policy and the uncertain support of allies, this argument has some merit. Other nations, such as Israel, have found that they cannot count on the support of all their allies in time of war. France has held up shipment of spare parts for the planes it has sold to Israel because it has, at times, disagreed with Israeli policy in the Middle East. The United States could conceivably find itself in a similar position if it relied excessively on foreign firms for planes, firearms, and oil.

But even though the national defense argument has some validity, it is one that special-interest groups can easily abuse for private gain. The textile industry, for example, promotes itself as a ready source of combat uniforms during wartime. In years past, US oil producers, contending that a healthy domestic oil industry is vital to the national defense, have lobbied for protection from foreign oil in wartime. But the effects of a tariff are not necessarily those that are claimed. By making foreign oil more expensive, a tariff increases consumption of domestic oil stocks. Because oil is a finite resource, a tariff can ultimately make the United States more dependent on foreign energy sources in time of emergency. Also, it might be more efficient in many cases to buy products that are important for national defense from foreign suppliers and store sufficient quantities of them for emergencies. Since the United States is dependent on foreign oil, it stores large amounts of petroleum in the Strategic Petroleum Reserve as an emergency reserve.

Comparative wages

Politicians, pundits, and industry lobbyists often argue for protection on the grounds that, because workers are paid less in foreign countries, US industries cannot hope to compete with foreign imports. They fail to realize that trade depends on the relative costs of production, not absolute wage rates in various nations. US wages may be quite high in either absolute or relative terms, but the output of some worker groups that have relatively lower total production costs can still be exported. If some products from high-wage domestic workers are exported, then other products from other high-wage worker groups must be imported.

The important point is what tariffs do to trade. In the hypothetical example in Reading 5.1, the United States was more efficient than China in the production of both textiles and beef. That is, generally speaking, fewer resources were required to produce those goods in the United States than in China. Very possibly, the incomes of textiles and beef workers would be higher in the United States than in China, but because Chinese firms had a comparative cost advantage in textiles (measured in terms of the number of units of beef forgone for each textile unit), they were able to undersell textile firms in the United States. If the United States imposed tariffs or quotas on imported textiles because China had a comparative advantage in that product, it would destroy the basis for trade between the two nations. Reducing imports will tend to reduce exports, at least in the long run.
Who gets the money

Another argument for tariffs is based on the faulty idea that the United States necessarily loses when money flows overseas in payment for imports. As Abraham Lincoln is reported to have said: “I don’t know much about the tariff, but this I do know. When we trade with other countries, we get the goods and they get the money. When we trade with ourselves, we get the goods and the money.”

Lincoln was clearly right when he said he did not know much about the tariff. He failed to recognize the real income benefits of international trade, which are reduced by tariffs. He seems to have confused the nation’s welfare with its monetary holdings. It is true that, if Americans buy goods from abroad, Americans get the goods and foreigners get the money.2 But what are foreigners going to do with the money they receive? If they never spend the money they get from imports, Americans will be better off, for they will have obtained some foreign goods in exchange for some paper bills, which are relatively cheap to print (or, more likely, electronic blips on some bank’s computer). At some point, however, foreign exporters will want to get something concrete in return for their labor and materials. They will use their dollars to buy goods (or bonds and stock) from US manufacturers. Again, trade is a give-and-take process, in which benefits flow to both sides.
Lost jobs

The textile industry has complained (for what seems an eternity) that foreign imports of textile products are the cause of lost jobs in the US textile industry. It is true that American textile firms have closed lots of plants and laid off hundreds of thousands of textile workers since the 1960s, and textile imports are much higher today than they were in, say, the early 1970s. But are imports from China, Malaysia, the Philippines, and elsewhere fully to blame for lost US jobs? There are several considerations that need to be kept in mind:

● First, domestic textile firms have to compete with domestic competitors as well as foreign competitors. Without much question, many aggressively competitive American firms have helped to run many not-so-competitive American firms out of business over the years.

● Second, the textile industry, pressed by the forces of domestic and foreign competition, went through a technological revolution in the 1970s and 1980s, dramatically increasing their output per worker because of the replacement of fly shuttle-looms with water-jet and air-jet looms. From research conducted by one of the authors, this increase in productivity is responsible for a substantial share of employment loss in the industry (McKenzie 1987).

● Third, many American textile firms have closed because their cost of production has risen as the wages they have had to pay have risen (relative to wages elsewhere in the world). One of the reasons for this relative rise in wages is that the economies of key textile-producing states (North and South Carolina) have progressed economically with the expansion of their nontextile sectors, which has put upward pressures on the wages textile firms have had to pay. In short, the expansion of nontextile American industries has played a role in the contraction of the number of plants and employment in the American textile industry.

Some proponents of tariffs argue that if other nations impose tariffs on US goods, the United States must retaliate. Unless we respond in kind, foreign producers will have the advantage in both markets. This argument has a significant flaw. By restricting their imports, foreign nations reduce their ability to sell to the United States and other nations. To buy Chinese goods, for instance, Americans need yuan. They get yuan by selling to China. If China reduces its imports from the United States, Americans will have fewer yuan to buy Chinese goods. So, the Chinese are restricting their own exports with their tariffs: They harm themselves as well as Americans. If Americans respond to their actions by imposing tariffs of their own, they will reduce trade even further. The harm is compounded, not negated.

Nevertheless, “trade wars” can, and do, break out. The result is that nations impose restrictions on each other. Such wars can be mutually beneficial, but only if they make trading partners realize the universal benefits of free trade and move to negotiate bi- or multi-lateral reductions in the trade restrictions they have imposed.
Infant industries

Finally, tariff advocates sometimes claim that new industries deserve protection because they are too small to compete with established foreign firms. If these so-called “infant industries” are protected by tariffs, they can expand their scale of production, lower their production costs, and eventually compete with foreign producers. The problem with this argument is that it is very difficult for a government to determine which new industries may eventually be able to compete with foreign rivals. Over the long period of time that an industry may need to mature, conditions and the technology of production may change significantly. For an infant industry to become truly competitive, it must do more than become more productive and cost-effective through the achievement of scale economies: It must develop a comparative cost advantage.

Moreover, the mere likelihood that a firm will eventually be able to compete with its foreign rivals does not in itself warrant protection. Not until firms have become established will consumers receive the benefit of lower prices. In the interim, tariff protection hurts consumers by raising the prices they must pay. Proponents of protection must be able to show that the time-discounted future benefits to be gained by establishing an industry exceed the current costs of protecting it. Also, if an infant industry has enough political influence to get tariff protection when it is small, it will probably have enough to keep that protection when it gets larger. The steel industry has managed to keep its protection against imports for many decades after it justified that protection by claiming that it was necessary to become established.

Finally, if a firm can expand, cover all its costs of production, and eventually compete with its foreign rivals, private entrepreneurs as well as government officials can be expected to see the eventual economies. Entrepreneurs are not likely to miss the opportunity to invest in companies that have the chance of achieving the required comparative advantages. Through the stock and bond markets, firms with growth potential will be able to secure the funds they need for expansion. If a firm cannot raise capital from private sources, it may be because the return on the investment is too low in relation to the risk. Why should the government accept risks that the private market will not accept? Should anyone really expect policy makers and government workers to be better at assessing profitable opportunities than private entrepreneurs?

China’s trade surplus with the United States

During the 1990s and early 2000s, the United States had a growing deficit in the trade of goods with China. In 1994, the goods deficit was between $29 billion and $30 billion. By 2000, it had risen to almost $83 billion. By 2008, it had surpassed $250 (Reuters 2009). Proponents of tariffs and quotas on Chinese imports, especially textile imports, pointed to how China had pegged its currency, the yuan, against the dollar. This meant that while the dollar rose and fell with respect to other currencies, the yuan price of the dollar remained more or less stable. Proponents of US protectionism argued that one of the reasons for the “invasion” of Chinese goods into the United States is that China had chosen an exchange rate that artificially hiked the yuan price of the dollar, making Chinese goods artificially cheap in the United States. Hence, according to critics of China’s exchange rate policy, US textile manufacturers, especially, needed protection to offset the inflated value of the dollar (Frauenheim 2005; Los Angeles Times Wire Service 2005; Navarro 2008).

Bottom line

The economic case for free trade is strong. The economic case for restricted trade is generally flawed.

Review question

Suppose that in the midst of a recession in which unemployment is rising, someone writes a commentary in your local newspaper advocating that federal and state governments buy only domestic goods and services on the grounds that domestic unemployment will be reduced. How would you react to such an argument?

Figure 5.2.1 Effect of tariff protection on individual industries: case 1

If neither the textiles nor the automobile industry obtains tariff protection, the economy will earn its highest possible collective income (Cell I), but each industry has an incentive to obtain tariff protection for itself. If the textiles industry alone seeks protection (Cell II), its income will rise while the auto industry’s falls. If the auto industry alone seeks protection, its income will rise while that of the textile industry falls. If both obtain protection, the economy will end up in Cell IV, its worst possible position. Income in both sectors will fall.

Figure 5.2.2 Effects of tariff protection on individual industries: Case 2

In this case, the auto industry gains from tariff protection, even if both sectors are protected (Cell IV). The textiles industry’s income falls from $20 (Cell I) to $17 (Cell IV), but the auto indusry’s income rises from $30 (Cell I) to $31 (Cell IV). Thus the auto industry has no incentive to agree to eliminate the tariffs.

1 The nation could convert to the production of war-related goods, but the conversion process might be prohibitively lengthy and complex.

2 Actually, the transaction may not involve the transfer of paper money. It is more likely – as explained later in chapter 5 – that payment will be made by transferring funds from one bank account to another. The importer’s bank balance will drop, and the exporter’s bank balance will increase.

Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010

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